Inflation to remain a structural challenge around the world

Ion Dan
Friday 23 March 2018

Despite occasional fears of a sudden onset of inflation — such as the recent market volatility that some thought may be related to building inflation pressures — generally, inflation has remained low, part of the challenge in the low yield environment.

Synchronized global growth may support inflation cyclically, but issues such as the continuing disconnect between ultralow unemployment and only modest inflation and wage growth continues to puzzle investors. In the sections that follow, we use visuals to help explain our views on macro inflation, the headwinds to significantly higher interest rates, a look to Japan for points of comparison to the United States, and the current backdrop globally — and how modest inflation coupled with high levels of indebtedness remain structural challenges in the years to come. 

Inflation is the result of demand exceeding supply

Fragile economic growth and a lack of inflation since the global financial crisis have been key reasons for accommodative central bank policies. More recently, economic activity has been improving, leading a number of central banks to gradually remove monetary stimulus. In particular, the US Federal Reserve is the furthest down the tightening road, in spite of inflation remaining below 2%.

Over the short term, as long as growth remains solid, inflation is likely to moderately increase, but at the same time the lagged impact of tighter monetary policy will trickle in.

Economic growth trending better, while inflation remains temperate

Data: US Bureau of Economic Analysis

Data: US Bureau of Economic Analysis

Fears of disinflation have abated

Several years of ultralow and negative interest rates and sluggish growth triggered fears of disinflation — or slowing price increases — and even talk of deflation. Economic improvements and the rebound in commodity prices have led to a modest tailwind to inflation globally.

However, the price bounce in commodities remains relatively muted, supporting our view that in the medium term inflation will generally undershoot targets.

Price levels finding their footing…

Data: Eurostat; US Bureau of Economic Analysis; US Energy Information Administration

…though commodities remain subdued

Data: Bloomberg

Some labor slack remains, while wages and inflation have been contained

US unemployment improved, as did wages. However, jobs created since the global financial crisis disproportionately have been part-time, lower-paying work.

Labor market conditions remain below levels seen in 2006-2007 and in the early 2000s when wage growth was above 4%. Additionally, the link between wages and inflation bears close watching, as historical relationships are not stable.

Labor markets presumably on the mend, but mixed signals exist

Data: Federal Reserve Bank of Kansas City; Federal Reserve Bank of Atlanta (both series available through Federal Reserve Bank of St. Louis)

Data: US Bureau of Economic Analysis; US Bureau of Labor Statistics

The Phillips curve is not statistically significant

The Phillips curve refers to the relationship between unemployment and wages, specifically that as the unemployment gap is closing (current employment is below the “natural rate of unemployment”), wage pressures should heat up. The natural rate of unemployment is estimated by the Congressional Budget Office as an equilibrium level of employment that is noninflationary.

However, the statistical relationship between the unemployment gap and wages is tenuous (-0.25 correlation, 0.06 R-squared). Historically, a stronger relationship existed prior to 1990, but over the past three decades when the unemployment gap closed, the response in wages and inflation has been more muted.

Monthly observations, 1965–2017

Data: US Bureau of Labor Statistics; Macquarie Investment Management

Unemployment gap has grown less influential on wages and inflation

Data: US Bureau of Labor Statistics; Macquarie Investment Management

Japan: A Phillips curve case study

The continuing inflation dilemma facing much of the world may have some clues in the case study of Japan. As of January 2018, the Japanese economy has seen positive growth for seven consecutive quarters for an average annual gross domestic product (GDP) growth rate of 1.9%. Unemployment was a very low 2.8% with labor shortages in several sectors — yet at the same time, the country has seen virtually no inflation. In fact, deflation occurred when unemployment rates increased, while better employment led to inconsistent inflation outcomes.

The Japanese Phillips curve is considered to have collapsed. One factor may be that workers in Japan, after decades of stagnation and economic downturn, may value job security over wage growth, which could be a similar factor in the US and other countries where memories of the financial crisis still loom.

An inconsistent relationship between unemployment and inflation

Data: Organization for Economic Co-operation and Development

Data: Organization for Economic Co-operation and Development

US home prices not supported by growing real wages, while higher rates reduce affordability

Housing affordability is typically affected by higher wages and lower mortgage rates. Currently, home prices are running ahead of borrowers’ real incomes, while affordability will likely decrease if mortgage rates move higher.

Housing market appears less likely to contribute to inflation

Data: US Bureau of Labor Statistics; US Federal Housing Finance Agency

Data: National Association of Realtors; Federal Home Loan Mortgage Corporation

What the outlook for inflation means for bond investors

What can investors expect in 2018 for inflation?

To begin with, economic growth is likely to be challenged structurally, although aspects such as tax cuts, infrastructure spending, and deregulation can help in the short term. However, significant headwinds, from debt to demographics, remain.

Global nonfinancial sector, debt-to-GDP

Data: Bank for International Settlements

Furthermore, inflation should remain stable in the medium term, in our view, due to lack of wage growth. There is also short-term upside risk.

Another factor to consider is that central banks’ actions can be significant — the outlook for the Fed is for two rate hikes, or possibly three, in 2018. Four rate hikes without an increase in inflation opens the door to policy error.

It is important to remember that risk is amplified in a low yield environment, and bonds remain a critical diversifier for portfolios. As many investors are concerned about potentially higher rates yet add risk assets to their portfolios, prudent choices such as considering longer duration become even more important.